Given the blitz of big-bank bombshells from the Federal Reserve, one might not think Gov. Tarullo has it in mind to take back Basel III’s advanced requirements. But, he stunned a Federal Reserve of Chicago meeting yesterday morning with this proposal. Is it a cease-fire? I don’t think so – rather it’s an effort to swap big-bank capital models with the Fed’s own stress-test ones, presumably because the Fed likes its better than theirs. Will abandoning Basel for more stress tests work? I doubt it, but even the suggestion that the U.S. will walk away from Basel III standards could drive a knife into the heart of these already-gasping global requirements. Mr. Tarullo thinks a new global regime based on robust stress tests will emerge. I won’t wait up.

First, to why stress tests aren’t a substitute for rigorous risk-based capital (RBC). Before going on to the substance of my worries here, the political realities warrant a look. If the U.S. abandons Basel III, Basel’s hard slog towards comparable, sensible risk weightings will end in quicksand. The global rules will not be implemented in most countries in anything like their current form, but the replacement stress tests Mr. Tarullo envisions will take their place in only a few countries and then in widely-varying form. The EU is embarking for the first time this year on stress tests that aren’t flat-out silly. Maybe they can keep this up and perhaps other countries will join them. But, not so far and for sure not fast.

But, assume Mr. Tarullo doesn’t really care which way those darn foreigners go now that he’s got a tough FBO rule that, he believes, keeps our borders safe from marauders. Does this proposed new capital regime make sense even then? A big part of the problem resides with how the floor is calculated – as noted, Mr. Tarullo thinks it’s Basel I for RBC combined with the tough new leverage standards.

At the Chicago meeting, I pointed to first-loss tranches in CDOs as a test case. Under Basel I, they get a 100 percent risk weighting, with the leverage rules set at three to six percent depending on the bank’s size. Under the advanced internal-ratings based (A-IRB) approach, these positions get at least dollar-for-dollar capital – maybe too much, but a lot closer to the economic capital needed to buttress these very, very high-risk positions.

How long will it take for the siren song of regulatory arbitrage to lure big banks into high-risk positions not captured by old-school Basel I weightings? Not long, I fear, especially given the ferocious competition coming at them from non-banks for low-risk assets where the new rules would set the bar far too high from an economic perspective.

Are my worries groundless? Not according to a senior OCC official, who followed my Chicago comments not only by agreeing with them, but also by taking strong issue with Mr. Tarullo’s idea. Some of the Fed staff there also seemed more than surprised to hear of it.

Mr. Tarullo is formidable, but not the emperor of the FRB’s rulebook and he also has no authority over the OCC or FDIC. The Fed could go his way for BHCs, using its own stress tests as the backstop Mr. Tarullo envisions. But, would national bank capital still be Basel III based? If so, how many competing rules with how many systems costing how much will big banks need to maintain to what end? So, the first obstacle — other than substance — to going back to days-gone-bye Basel is the need for agency consensus.

The second obstacle is the cost to global harmony.   One might well say that “harmony” is happy talk given the already widely differing ways that rules are implemented and the profound challenges confronting a credible cross-border resolution regime. But, if the U.S. walks away from Basel III, the fragile global framework will collapse, leaving U.S. banks in a fortress regulatory bulwark no one will dare enter and from which they will find it hard to compete against “shadow” firms – see my Chicago paper

If we walk away from Basel III, we might walk to better capital rules – although I doubt it. We for sure will walk away from the global efforts to craft cross-border standards. These are still more of a hope than a reality, but it’s a hope for something better the U.S. abandons at grave cost.